The following analysis of the unaudited condensed consolidated financial condition and results of operations of Arlington Asset Investment Corp. (Arlington Asset), formerly known as Friedman Billings Ramsey Group, Inc. (FBR Group) and its subsidiaries, including FBR Capital Markets Corporation (FBR Capital Markets) (unless the context otherwise provides, collectively, "we", "us", "our" or the "Company"), should be read in conjunction with (i) the Company's audited consolidated financial statements and notes thereto included in Annual Report on Form 10-K for the year ended December 31, 2008 and (ii) FBR Capital Markets' audited consolidated financial statements and notes thereto included in its Annual Report on Form 10-K for the year ended December 31, 2008.

The Company's unaudited condensed consolidated financial statements include the results of its former subsidiary, FBR Capital Markets through May 20, 2009. Prior to May 20, 2009, the Company's wholly-owned subsidiary, FBR TRS Holdings, Inc. (FBR TRS Holdings), owned approximately 56% of the outstanding shares of FBR Capital Markets. The Company liquidated 16,667,000 and 1,500,000 shares of FBR Capital Markets common stock on May 20 and June 19, 2009, respectively, resulting in remaining holdings representing an approximately 39% and 24% interest in FBR Capital Markets, respectively. The sale of 16,667,000 shares on May 20, 2009 was to FBR Capital Markets. As a result, effective May 20, 2009, the Company no longer had majority control of FBR Capital Markets and therefore, deconsolidated the results of FBR Capital Markets' activities in preparing the Company's consolidated financial statements. In addition, on July 15, 2009, the Company liquidated an additional 411,032 shares of FBR Capital Markets stock at a price of $4.42 per share in connection with the over-allotment option that was granted to the underwriters under the underwriting agreement entered into on June 15, 2009.

The discussion of the Company's consolidated financial condition and results of operations below may contain forward-looking statements. These statements, which reflect management's beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect the Company's future results, please see "Forward-Looking Statements" immediately following Item 4 of this report on Form 10-Q.

Business Strategy

The sale of FBR Capital Markets stock is in furtherance of the strategic shift the Company has initiated to focus on a principal investing strategy by monetizing our investment in FBR Capital Markets. Given recent dislocations in the capital markets, the Company seeks to benefit from potential high current cash returns available on mortgage investments. The Company plans to deploy the net cash proceeds for investments that offer current income as well as capital appreciation potential, and which may utilize the Company's net operating loss carry-forwards (NOLs) and net capital loss carry-forwards (NCLs). The Company expects future investments to include non-agency residential mortgage-backed securities (MBS) and residential MBS guaranteed by a U.S. Government agency or U.S. Government-sponsored entity, among others. The Company may also consider opportunities for financial service operating businesses potentially in the form of a bank charter, and will seek to continue strengthening its balance sheet by converting long-term debt to equity through the extinguishment of the remaining $15.0 million Trust Preferred securities at a discount to face value.

Executive Summary

As discussed above, we liquidated an additional 411,032 shares of FBR Capital Markets stock at a price of $4.42 per share on July 15, 2009 in connection with the over-allotment option that was granted to the underwriters under the underwriting agreement entered into on June 15, 2009. We have continued our efforts to divest our holdings in FBR Capital Markets to further fund the principal investing strategy. Accordingly, on October 28, 2009, the Company announced the closing on the sale of 14,755,017 shares of FBR Capital Markets common stock at $6.00 per share in an underwritten public offering. Proceeds to the Company, after the

underwriting discount but before expenses, were $84.1 million. The net price per share after the underwriting discount to the Company of $5.70, is less than the carrying value of the FBR Capital Markets stock of $5.93 at September 30, 2009, and will result in the Company recording a pre-tax book loss of $3.4 million during the quarter ending December 31, 2009. These shares represented the Company's remaining interest in FBR Capital Markets.

During the quarter ended September 30, 2009, we recorded $18.1 million in unrealized gains resulting from the change in the fair value of FBR Capital Markets stock as a component of investment income on the income statement.

Our efforts to continue the extinguishment of the remaining Trust Preferred securities resulted in an additional extinguishment of $35.0 million of Trust Preferred securities at a gain of $28.0 million for the three months ended September 30, 2009. As of September 30, 2009, we have $15.0 million in remaining Trust Preferred securities.

The results of the Company's operations, without the results of FBR Capital Markets' operations, as compared to the results of consolidated operations as reported, for the three and nine months ended September 30, 2009 are as follows (dollars in thousands):

   Pro Forma Results of Operations, Excluding FBR Capital Markets' Operations



                                              Three Months Ended                   Nine Months Ended
                                              September 30, 2009                   September 30, 2009
                                        Pro forma         As Reported        Pro forma         As Reported
Revenues:
Capital markets                         $       -        $          -        $       -        $      81,075
Principal investment:
Interest                                     3,719               3,719            7,600               7,600
Net investment income                       19,737              19,737           15,754              15,754
Dividends                                       -                   -               108                 108

Total revenues                              23,456              23,456           23,462             104,537
Interest expense                               310                 310            3,405               3,656

Revenues, net of interest expense           23,146              23,146           20,057             100,881

Non-Interest Expenses:
Compensation and benefits                    2,735               2,735           13,238              73,466
Professional services                          878                 878            5,997              12,871
Business development                            16                  16            7,900              13,139
Clearing and brokerage fees                     -                   -                -                5,950
Occupancy and equipment                         94                  94              416              13,573
Communications                                 100                 100              247               8,964
Other operating expenses                     1,163               1,163            3,857              10,099

Total non-interest expenses                  4,986               4,986           31,655             138,062

Operating income (loss)                     18,160              18,160          (11,598 )           (37,181 )

Other Income (Loss):
Loss on subsidiary share
transactions                                  (116 )              (116 )        (10,028 )           (10,028 )
Gain on extinguishment of long-term
debt                                        27,982              27,982          160,435             160,435
Other loss                                      (4 )                (4 )            (11 )               (11 )

Income before income taxes and
noncontrolling interest                     46,022              46,022          138,798             113,215
Income tax provision                         3,585               3,585           12,029              12,830

Net income                              $   42,437       $      42,437       $  126,769       $     100,385

With the Company's sale of its majority ownership interest in and resulting deconsolidation of FBR Capital Markets activities effective May 20, 2009, the Company's consolidated financial statements for the periods subsequent to May 20, 2009 no longer include the results of operations of FBR Capital Markets.

Beginning in the second quarter and continuing in the third quarter of 2009, we have continued our efforts to re-build our mortgage-backed securities (MBS) portfolio. Our strategy is to be selective in identifying non-agency senior MBSs that could provide attractive loss-adjusted yield on an unlevered basis. As of September 30, 2009, the Company had $55.7 million in unlevered non-agency MBS. We are also continuing to invest in agency MBS on a leveraged basis. As of September 30, 2009, the Company had $118.1 million in its agency MBS portfolio. We will continue to evaluate investment opportunities against the returns available in each of our investment alternatives and endeavor to allocate our assets and capital with an emphasis toward the highest risk-adjusted return available. This strategy may cause us to have different allocations of capital in different environments.

Principal Investing

Mortgage-Backed Securities

The Company recorded net interest income of $3.6 million and $7.7 million from MBS held in its principal investment portfolio for the three months ended September 30, 2009 and 2008, respectively. The Company recorded net interest income of $7.2 million and $22.6 million from MBS held in its principal investment portfolio for the nine months ended September 30, 2009 and 2008, respectively. The decrease in net interest income during the three and nine months ended September 30, 2009 is due mainly to the decrease in the average balance of MBS investments held in our portfolio offset by the increase in the average yield.

Merchant Banking and Other Investments

The total value of our merchant banking portfolio and other investments was $90.1 million as of September 30, 2009. Of this total, $87.5 million represents an investment in FBR Capital Markets, $1.5 million was held in the merchant banking portfolio and $1.1 million was held in alternative asset funds. There were no unrealized losses in the merchant banking portfolio included in accumulated other comprehensive income (AOCI) as of September 30, 2009.

During the three and nine months ended September 30, 2009, we recorded $0.5 million and $2.0 million, respectively, in other-than-temporary impairment write-downs as part of the Company's quarterly assessments of unrealized losses in its merchant banking and other investment portfolio.

Results of Operations

Three months ended September 30, 2009 compared to three months ended September 30, 2008

The Company had net income of $42.4 million in the third quarter of 2009 versus a net loss of $169.0 million in the third quarter of 2008. Net income (loss) included the following results of operations by segment (dollars in thousands):

                                                                    For the quarter ended
                                                                        September 30,
                                                                     2009           2008
Capital markets                                                   $        -     $  (46,682 )
Principal investing                                                    18,160      (157,728 )
Other                                                                      -           (695 )

Operating income (loss)                                                18,160      (205,105 )
Gain on extinguishment of long-term debt and other losses              27,862         4,074

Income (loss) before income taxes and noncontrolling interest          46,022      (201,031 )
Income tax provision (benefit)                                          3,585       (18,123 )
Noncontrolling interest in losses of consolidated subsidiary               -        (13,886 )

Net income (loss) attributable to Arlington Asset shareholders    $    42,437    $ (169,022 )

Net income for the third quarter of 2009 is primarily due to the gain on extinguishment of long-term debt and investment income from fair value changes in our investment in FBR Capital Markets common stock. Net loss for the third quarter of 2008 was primarily the result of other-than-temporary impairment losses recorded on our MBS investments and losses generated by FBR Capital Markets.

The Company's revenues, net of interest expense, increased to $23.1 million in the third quarter of 2009 from $(103.7) million in the third quarter of 2008 due to the changes in revenues and interest expense described below.

Revenues from our principal investment activities, net of related interest expense, totaled $23.3 million in the third quarter of 2009 as compared to a loss of $145.0 million in the third quarter of 2008. The change in net revenues is primarily the result of the recognition of other-than-temporary impairment losses related to the Company's MBS portfolio during the third quarter of 2008. No other-than-temporary impairments were recognized in the third quarter of 2009 related to the MBS portfolio. In addition, the Company recognized net investment income on the fair value change of our investment in FBR Capital Markets common stock for the third quarter of 2009. These investment gains were partially offset by a decrease in MBS interest income resulting from lower average MBS balances. Revenues from our principal investment activities included the following (dollars in thousands):

                                                         For the quarter ended
                                                             September 30,
                                                          2009           2008
    Net interest income                                $     3,605    $    7,949
    Net investment income (loss)-principal investing        19,737      (153,110 )
    Dividend income                                             -            158

    Principal investment income (loss)                 $    23,342    $ (145,003 )

The components of net interest income from principal investing segment are summarized in the following table (dollars in thousands):

                                        Three months ended                         Three months ended
                                        September 30, 2009                         September 30, 2008
                                 Average      Income         Yield          Average      Income         Yield
                                 Balance     (Expense)       (Cost)         Balance     (Expense)       (Cost)
Mortgage-backed securities(1)   $ 166,271   $     3,717        8.94 %     $ 2,525,719   $   22,923        3.63 %
Other(2)                                              2                                        250

                                                  3,719                                     23,173

Repurchase agreements           $ 100,575          (114 )     (0.45 )%    $ 2,189,574      (14,259 )     (2.55 )%
Derivative contracts(3)                              -                                        (965 )

                                $ 100,575          (114 )     (0.45 )%    $ 2,189,574      (15,224 )     (2.78 )%

Net interest income/spread                  $     3,605        8.49 %                   $    7,949        0.85 %

(1) The average balance and the yield are calculated based upon the adjusted par value which includes the effects of any other-than-temporary impairments recorded by the Company. The yield based on unadjusted par value was 7.09% and 3.59% for the three months ended September 30, 2009 and 2008, respectively.

(2) Includes interest income on cash and other miscellaneous interest-earning assets.

(3) Includes the effect of derivative instruments accounted for as cash flow hedges.

As shown in the table above, net interest income decreased by $4.3 million to $3.6 million during the three months ended September 30, 2009 compared to $7.9 million during the three months ended September 30, 2008. This decrease in interest income was primarily due to a lower average balance on the MBS portfolio.

The Company recognized net investment income of $19.7 million during the third quarter 2009 compared to a net investment loss of $153.1 million in the third quarter 2008. The following table summarizes the components of net investment income (loss) (dollars in thousands):

                                                                 Three months ended
                                                                    September 30,
                                                                2009            2008
Available for sale and cost method
securities-other-than-temporary impairments                   $    (86 )     $ (118,720 )
Fair value change in investment in FBR Capital Markets
stock                                                           18,149               -
Losses from investments funds                                     (399 )         (1,448 )
Realized gains (losses) on sale of available for sale
investments, net                                                 1,822          (24,474 )
Other net investment income (loss)                                 251           (8,468 )

Net investment income (loss)                                  $ 19,737       $ (153,110 )

As part of the Company's quarterly assessments of unrealized losses in its portfolio of marketable equity securities for potential other-than-temporary impairments and its assessment of cost method investments, the Company recorded $0.1 million of other-than-temporary impairment losses during the three months ended September 30, 2009 as compared to $16.3 million for the same period in 2008.

Fair value change in investment in FBR Capital Markets stock reflects the change in fair value of FBR Capital Markets stock during the quarter ended September 30, 2009.

Loss from investment funds reflects the earnings from and valuation adjustment of investments in proprietary investment partnerships and other managed investments.

Other net investment income (loss) primarily includes net gains and losses from the changes in the fair value of investments in our MBS portfolio and derivative transactions.

Principal investing interest revenue decreased 84.1% to $3.7 million in the third quarter of 2009 from $23.2 million in the third quarter of 2008. Net investment income increased to $19.7 million in the third quarter of 2009 from a loss of $153.1 million in the third quarter of 2008. The decrease in interest income year over year was a result of the lower average balance in the MBS portfolio as a result of the downsizing effort to reduce exposure to deteriorating market conditions while at the same time generating additional cash to fund the extinguishment of long-term debt in the first quarter of 2009. The change in net investment income (loss) is primarily the result of increase in fair value of our investment in FBR Capital Markets' common stock and no recognition of other-than-temporary impairment losses related to the Company's MBS portfolio during the third quarter of 2009.

Interest expense, related primarily to long-term debt issued through FBR TRS Holdings, decreased 98.8% to $0.3 million in the third quarter of 2009 from $25.4 million in the third quarter of 2008 as a result of a decrease in outstanding principal balances due to the extinguishment during the first and third quarters of 2009 and lower LIBOR based interest rates associated with these floating rate borrowings.

Total non-interest expenses decreased 95.1% to $5.0 million in the third quarter of 2009 from $101.4 million in the third quarter of 2008. The decrease was primarily attributable to the deconsolidation of FBR Capital Markets' activities during the second quarter of 2009 and the results of the cost reduction efforts taken during the last year.

The Company had an income tax provision of $3.6 million in the third quarter of 2009 as compared to an income tax benefit of $18.1 million in the third quarter of 2008. The decrease is due primarily to the recording of the tax provision due to the discrete period reporting of the tax effects of the gain recognized from the extinguishment of debt during the first and third quarters of 2009. Our effective tax rate was 6.7% in the third quarter of 2009 as compared to 41.0% in the third quarter of 2008. For the third quarter of 2009, our deferred tax assets continue to reflect a full valuation allowance as the Company believes it is more likely than not that the benefits will not be realized in the future.

Subsequent to the deconsolidation of FBR Capital Markets effective May 20, 2009, the Company no longer records activities related to the noncontrolling interest of consolidated subsidiary. $13.9 million of net loss attributable to the noncontrolling interest of consolidated subsidiary for the third quarter of 2008 represents minority interest holders' share of losses of FBR Capital Markets during that period.

Results of Operations

Nine months ended September 30, 2009 compared to nine months ended September 30, 2008

Net income increased to $111.8 million in the nine months ended September 30, 2009 from a loss of $149.0 million in the nine months ended September 30, 2008. Net income included the following results of operations by segment (dollars in thousands):

                                                                  Nine Months Ended
                                                                    September 30,
                                                                2009             2008
Capital Markets                                               $ (25,583 )     $  (92,886 )
Principal Investment                                            (11,598 )       (189,150 )
Other                                                                -            (3,810 )

Operating loss                                                  (37,181 )       (285,846 )
Net income from extinguishment of debt, subsidiary share
transactions and other                                          150,396           76,919

Income (loss) before taxes and noncontrolling interest          113,215         (208,927 )
Income tax provision (benefit)                                   12,830          (28,903 )
Noncontrolling interest in losses of consolidated
subsidiary                                                      (11,459 )        (31,053 )

Net income (loss) attributable to Arlington Asset
shareholders                                                  $ 111,844       $ (148,971 )

Net income for the first nine months of 2009 is primarily due to the gain on extinguishment of long-term debt and investment income from fair value changes in our investment in FBR Capital Markets common stock. Net loss for the first nine months of 2008 was primarily the result of other-than-temporary impairment losses recorded on our MBS investments and losses generated by FBR Capital Markets.

The Company's revenues, net of interest expense, increased to $100.9 million in the first nine months of 2009 from $38.0 million in the first nine months of 2008 due to the changes in revenues and interest expense described below.

Revenues from our principal investment activities, net of related interest expense, totaled $23.0 million in the first nine months of 2009 as compared to a loss of $147.9 million in the first nine months of 2008. The change in net revenues is primarily the result of the recognition of other-than-temporary impairment losses related to the Company's MBS portfolio and a residual interest in a securitization of non-prime mortgage loans during the first nine months of 2008. No other-than-temporary impairments were recognized in the first nine months of 2009 related to MBS or a residual interest in a securitization. In addition, the Company recognized net investment income on the fair value change of our investment in FBR Capital Markets common stock subsequent to May 20, 2009. These investment gains were partially offset by a decrease in MBS interest income resulting from lower average MBS balances. Revenues from our principal investment activities included the following (dollars in thousands):

                                                           Nine Months Ended
                                                             September 30,
                                                           2009        2008
      Net interest income                                $  7,186   $   24,924
      Net investment income (loss)-principal investing     15,754     (173,311 )
      Dividend income                                         108          497

      Principal investment income (loss)                 $ 23,048   $ (147,890 )

The components of net interest income from mortgage investments are summarized in the following table (dollars in thousands):

                                                       Nine Months Ended September 30,
                                               2009                                       2008
                                 Average      Income         Yield          Average       Income        Yield
                                 Balance     (Expense)       (Cost)         Balance     (Expense)       (Cost)
Mortgage-backed securities(1)   $ 116,639   $     7,579        8.66 %     $ 2,246,956   $   68,551        4.07 %
Other(2)                                             21                                      2,316

                                                  7,600                                     70,867

Repurchase agreements           $  78,863          (414 )     (0.70 )%    $ 1,971,449      (44,023 )     (2.93 )%
Derivative contracts(3)                              -                                      (1,920 )

                                $  78,863          (414 )     (0.70 )%    $ 1,971,449      (45,943 )     (3.11 )%

Net interest income/spread                  $     7,186        7.96 %                   $   24,924        0.96 %

(1) The average balance and the yield are calculated based upon the adjusted par . . .